There are a myriad of articles that take a stab at explaining investment management fees. The reality is that fees vary significantly based on what is being bought or sold and by whom (i.e. registered investment advisor or broker/agent). I’d like this short article to serve as a practical reference to the world of investment management fees. It is not meant to be a long detailed explanation of every single fee out there — my goal isn’t to put you to sleep. If you would like more detail, then by all means Google the specific terms I mention and get your hands dirty. I am simply seeking to arm you with the knowledge to make wise financial transactions and protect you against unnecessary and excessive fees. Sound good? Let’s dive in…
To keep things simple, we will explore two main layers of fees: External and Internal. External fees occur outside the financial product and internal fees occur inside the financial product as an operating expense.
Advisor (Management) Fees: If you are purchasing your investment through a financial advisor or investment professional, they will likely charge you a fee to have them manage your investments. The industry typically refers to this as an investment management fee and averages between 1-2% of assets (i.e. A $100,000 investment could cost you between $1,000 – $2,000 annually). In recent years, thanks to technology and higher overall awareness, these fees have fallen closer to an average of 1%. Investment advisors most often have a fee schedule that includes breakpoints based on the overall AUM (investment Assets Under Management) that the client entrusts the advisor with. As the amount of investment AUM reaches these breakpoints, the fee is reduced (much like the marginal tax brackets in the U.S., but in reverse).
- If your investment advisor is not transparent with this fee you can look up their Form ADV Part 2 at https://adviserinfo.sec.gov/. This form provides a full-disclosure of the fee structure which can be found under “Item 5: Fees and Compensation”.
- This fee is typically negotiable with the advisor.
- These days, you should not be paying more than 1% on investments. If you are being charged more, you better be receiving personalized financial planning services.
Sales Fees (commission-based): These costs are only associated with agents/brokers who sell financial products as they serve as their commission. Here is a short list of such fees:
- Load Fees: the agent receives a large commission up front when the investment is purchased (front-loaded) or sold (back-loaded). These fees are most often between 3-8%. Examples include insurance/annuity products and A-share mutual funds.
- On-going sales fee: the agent receives a reduced commission relative to the load fee (1-3% most of the time), but the fee is paid annually for the duration of the investment. While they appear to be lower than front-loaded fees, these can ultimately be more expensive when held over a longer duration. Examples include insurance/annuity products and C-share mutual funds.
- Agents/brokers selling commission-based products are not held to the fiduciary standard of doing what is best for the client. They are instead held to a suitability standard that provides a lot of wiggle room, meaning you may not be buying a product that is right for you holistically.
- Commission-based financial products provide many conflicts of interest. An agent/broker may be incentivized to sell you one product over the other because he/she may receive a higher commission.
Trading Cost (External): This is a custodial fee for completing a buy or sell order of a security trade. This cost varies based on the company holding your investments. Low-cost custodians like TD Ameritrade, Schwab, Fidelity, and E*Trade will often times charge fees of less than $10 per trade.
Important Takeaway: Each custodian has a list of securities that they do not charge trading fees to buy or sell. These can be found by searching for no cost ETFs, index funds, or mutual funds with your current custodian. This is a huge benefit for investment accounts with low balances.
Expense Ratio: An annual fee that all funds charge, and one that shareholders automatically pay through a deduction from their investment balance. This fee can range between 0.05% and 2%. Here are a couple general rules with expense ratios:
- Passively managed funds have lower expense ratios than actively managed funds (Read more about this in our article Active vs Passive Investing)
- International and emerging markets funds will have a higher expense ratio than domestic funds
12B-1 Fees: Fees that the mutual fund manager may charge for marketing and distribution of its fund. It is most often used as a disguised commission for the selling broker/agent. This fee is becoming less often incorporated into funds but is still worth noting as the advisor compensation portion can be between 0.25-0.75% annually. While this fee is often times included as part of the overall expense ratio, it’s worth making sure that the funds you own don’t have these fees included or at least aren’t excessive. You can read more about these fees here.
Trading Costs (Internal): Investment managers incur trading costs from buying and selling individual positions within the fund. This cost can go up based on the bid-ask spread (description below) of the stock and the number of trades inside the fund. Internal trading costs are unavoidable, so don’t worry about trying to find ways to minimize them.
If you’re not familiar with the concept of a bid-ask spread, let’s pretend you’re selling a tent on eBay. If you’re selling the only tent of its kind, you could think it’s worth $500 (your ask) but buyers may bid only $300. Due to it being the only tent of its kind, there is not enough on the market to establish a market price and therefore has a larger bid-ask spread. If the tent is a popular item sold by many others, there is a purchase history of what the tent is going for and a clearer picture of what the tent is worth, resulting in a smaller bid-ask spread.
Insurance Product Costs: These costs are only associated with insurance-based investment products in the form of an annuity, or an investment inside a life insurance policy. Insurance comes with a premium so these fees can really add up! For example, most variable deferred annuities have all-in costs of 2.5% to 4% per year, not including all the sales commissions that are often attached to them. There are four main types of charges within insurance products:
- Insurance related charges that include mortality and expense (M&E) fees and administrative fees.
- Surrender charges that are charged if you decide you want out of your investment early. These can be excessive and are not often disclosed clearly to the client.
- Rider charges for any additional “benefits” that you would like baked into your product. The most common one here tends to be a guaranteed income rider, because everyone is a sucker for “guaranteed” income. However, you’ll pay the price for this and it very rarely ever pays off.
- Investment management fees that the insurance company charges on the investments within the insurance product. In addition to these fees, you’ll also still be responsible for each of the funds’ expense ratios!
Important Takeaway:Because of all these additional layers of fees, it is very rare that an investment in an insurance product will turn out to be a wise purchase.
Conclusion: Due to the large range in potential fees, your investment success can largely depend on your ability to minimize the expenses associated with your investments. While you may feel overwhelmed by all these different types of fees, the most important thing is to simply be aware of them. That way you can ask the right questions to a professional and make sure they are fully disclosing all the fees related to your investments.